Let’s just say it as it is – I was very positively surprised by the massive response to my post on the economic legacy of Hugo Chavez. However, as somebody who primarily wants to blog about monetary policy it is a bit frustrating that I attract a lot more readers when I write about dead authoritarian presidents rather than about my favourite topic – monetary policy.
So I guess I have to combine the two themes – dead presidents and monetary policy. Therefore this post on my modest proposal for post-Chavez monetary reform in Venezuela.
It is very clear that a key problem in Venezuela is the high level of inflation, which clearly has very significant negative economic and social implications. Furthermore, the high level of inflation combined with insane price controls have led to massive food and energy shortages in Venezuela in recent years.
Obviously the high level of inflation in Venezuela is due to excessive money supply growth and there any monetary reform should have the purpose of bringing money supply growth under control.
A Export Price Norm will bring nominal stability to Venezuela
Market Monetarists generally speaking favour nominal GDP targeting or what we also could call nominal demand targeting. For large economies like the US that generally implies targeting the level of NGDP. However, for a commodity exporting economy like Venezuela we can achieve nominal stability by stabilizing the price of the main export good – in the case of Venezuela that is the price of oil measured in Venezuelan bolivar. The reason for this is that aggregate demand in the economy is highly correlated with export revenues and hence with the price of oil.
I have therefore at numerous occasions suggested that commodity exporting countries implement what I have called an Export Price Norm (EPN) and what Jeff Frankel has called a Peg-the Export-Price (PEP) policy.
The idea with EPN is basically that the central bank should peg the country’s currency to the price of the main export good. In the case of Venezuela that obviously would be the price of oil. However, it is not given that an one-to-one relationship between the bolivar and the oil price will ensure nominal stability.
My suggestion is therefore that the bolivar should be pegged to basket of 75% US dollars and 25% oil price. That in my view would view would ensure a considerable degree of nominal stability in Venezuela. So in periods of stable oil prices the Venezuelan bolivar would be more or less “fixed” against the US dollar and that likely would lead to nominal GDP growth in Venezuela that would be slightly higher than in the US (due to catching up effects in Venezuelan productivity), but in periods of rising oil prices the bolivar would strengthen against the dollar, but keep nominal GDP growth fairly stable.
EPN is preferable to a purely fixed exchange rate regime
My friend Steve Hanke has suggested that Venezuela implements a currency board against the dollar and permanently peg the Venezuelan bolivar to the dollar. However, that in my view could have a rather destabilizing impact on the economy.
Imagine a situation where oil prices increase by 30% in a year (that is not usual given what we have seen over the past decade). In that scenario the appreciation pressures on the bolivar would be significant, but as the central bank was pegging the exchange rate money supply growth would increase significantly to curb the strengthening of the currency. That would undoubtedly be inflationary and could potentially lead to a bubble tendencies and an increase the risk of a boom-bust in the economy.
If on the other hand the bolivar had been pegged to 75-25% basket of US dollars and oil then an 30% increase in the oil prices would lead to an appreciation of the bolivar by 7.5% (25% of 30%). That would counteract the inflationary tendencies from the rise in oil prices. Similar in the case of a sharp drop in oil prices then the bolivar would “automatically” weaken as if the bolivar was freely floating and that would offset the negative demand effects of falling oil prices – contrary to what happened in Venezuela in 2008-9 where the authorities tried to keep the bolivar overly strong given the sharp drop in oil prices. This in my view is one of the main cause for the slump in Venezuelan economic activity in 2008-9. That would have been avoided had the Venezuelan central bank operated EPN style monetary regime.
I should stress that I have not done detailed work on what would be the “optimal” mixed between the US dollar and the oil price in a potential bolivar basket. However, that is not the important thing with my proposal. The important thing is that such a policy would provide the Venezuelan economy with an stable nominal anchor while at the time reduce the risk of boom-bust in the Venezuelan economy – contrary to what have been the case in the Chavez years.
Time to get rid of currency and price controls
The massively unsustainable fiscal and monetary policy since 1999 have “forced” the Venezuelan government and central bank to implement draconian measures to control prices and the exchange rate. The currency controls have lead to a large black market for foreign currency in Venezuela and at the same time the price controls have led to massive energy and food shortages in Venezuela.
Obviously one cannot fight inflation and currency depreciation with interventionist policies. Therefore, this policies will have to be abandoned sooner rather than later as the cost of these policies are massive. Furthermore, it is obvious that the arguments for these policies will disappear once monetary policy ensures nominal stability.
End monetary funding of public finances
A key reason for the high level of inflation in Venezuela since 1999 undoubtedly has to be explained by the fact that there is considerable monetary financing of public finances in Venezuela. To end high-inflation it is therefore necessary to stop the central bank funding of fiscal policy. That obviously requires to bring the fiscal house in order. I will not touch a lot more on that issue here, but obviously there is a lot of work to be undertaken here. A place to start would obviously be to initiate a large scale (re)privatization program.
A modest proposal for monetary reform
We can therefore sum up my proposal for monetary reform in Venezuela in the following four points:
1) Introduce an Export Price Norm – peg the Bolivar to a basket of 75% US dollars and 25% oil prices
2) Liberalize capital and currency controls completely
3) Get rid of all price and wage controls
4) Separate fiscal policy and monetary policy – stop monetary funding of the public budget
I doubt that this post will be popular as my latest post on Venezuela, but I think that this post is significantly more important for the future well-being of the Venezuelan economy and a post-Chavez regime should move as fast as possible to implement monetary reform because without monetary reform the Venezuelan economy is unlikely to fully recover from its present crisis.
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Jeffrey Frankel has made a similar proposal for the Gulf States. Have a look at Jeff’s proposal here.
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Update: Steve Hanke has a comment on his suggestion for full dollarization in Venezuela. Even though I prefer my own EPN proposal I must say that Steve’s idea has a lot of appeal given the obvious weakness of public institutions in Venezuela and a very long history (pre-dating Chavez) of monetary mismanagement.
Isabella
/ March 9, 2013Mr Christensen, thanks for your proposal, it is quite refreshing. I acknowledge that Venezuela must lift its capital and currency controls. While the official exchange rate for the Bsf is 6.30 (depends on the cases), in the black market you can get a dollar for about 22-23 BSF. So my question is, if the government were to implement the EPN, which are the social-economic-political consequences in the short run?
Lars Christensen
/ March 9, 2013Isabella,
Thank you for your question. There would be numerous impacts of my proposal. First of all I would expect inflation to decline significantly – mostly likely to well-below 10% very fast. Second, as price controls are lifted food and energy shortages would end immediately.Third with no capital and currency controls the black market for currency would disappear overnight.
The important thing here is that these consequences would especially be beneficial to low-income groups. The groups the Chavez regime always have claimed to be fighting for.
Equally important with no currency and price controls corruption would likely drop significantly. I am sure that every Venezuelan is very well-aware with the amount of corruption that follows with these draconian price and currency controls.
Furthermore, I would note that in a situation where oil prices would be rising on the international markets the bolivar would be strengthening, which would lead to a decline in import prices and hence put significant downward pressure on none-energy prices. In that since you can say that the gain from higher oil prices “automatically” would be distributed among all Venezuelans.
Finally, for my proposal to be successful it is critically important that public finances are brought under control. Under the Chavez regime public expenditure growth has been more or less out of control – funded my oil revenues. That will have to end. I would start public finance reform through a process of re-privatisation of companies nationalized by the Chavez regime. This likely will be that hardest part of the reform, but it is necessary to get public finances in order to ensure a sustainable down in inflation. There is no way around it.
JP Koning
/ March 10, 2013I’ve got a technical question. I understand the idea of pegging to a basket of commodities, or to oil, or to $US. But I’m having troubles wrapping my head around the idea of defining a bolivar as as dollars & oil. Isn’t this like bimetallism? Aren’t we trying to peg to two different things?
Lars Christensen
/ March 10, 2013JPK, I can understand the confusion as I wasn’t very clear on the technical part of this.
I hope be careful using bimetallism as an analogy. A better way to think about it is that the central bank manages the bolivar against the dollar and on a daily basis announces a the target for USD/BSF it will hit today. It would change that “target” dependent on changes in the oil price.
Hence, it the price of oil increased by X% then the Venezuelan central bank would “automatically” revalue the bolivar Y% (dependent on the weights) against the dollar. With a 75/25 oil/usd basket a 30% increase in the oil price (against the dollar) would automatically lead to an 7.5% (30*0.25) appreciation of the bolivar against the dollar.
Alexander Guerrero
/ March 10, 2013Hi Lars, regards. Nothing like that you propose, which it looks very rational on the paper, will not function here. We have several institutional restrictions which determines the way oil rent is distributed between the oil rent owner, the Venezuelan government, and its partners, most of them, politically -rentist- engaged with Venezuelan economy, include Chinese mandarins, of course, estate and foreign governments owners corporations, even though Venezuela and PDVSA continue to have few private international oil corporations as partners is some “empresas mixtas”. The distribution of oil rent, government run, is totally tied with the way government redistribute it downstream “until it gets to people’s hands’. (more here http://www.alexanderguerrero.com)
These restrictions Lars, particular the oil rent ownership, which is executed by Venezuelan government, defines the way foreign exchange markets functions. The exchange rate system, the one under tight government control, like today’s, and any other one will operate tightly dependent of government fiscal stance and government finances. That is, government which runs as well Central Bank, which here is not an independent body but something like a development bank, -Chinese type, by the way- is going to devaluate any time it runs short of money. Just look at the history in the last 35 years.
In other words, inflation in Venezuela is really a pure inflation tax which runs from government devaluations for fiscal reasons,-all devaluations are fiscal run. Within this very restrictive institutional framework devaluation is a fiscal lever, this is a very important Chavez legacy regarding fiscal balances, the constitution and oil laws are extremely tight to the way oil rent is distributed in royalties (33%) taxes and dividends (56%) for government. So foreign exchange is monopolized by government, all incentives are out there for government to get as much bolivars for any oil dollars in its pockets, being Central Bank, sovereign funds and Treasure foreign accounts, if any,
Let’s just mention that in 1999 Chavez found exchange rate in 565 Bs/$, 13 years after, you pay 25 Bs/$ if you do not find in Venezuelan exchange control bodies. I remind you that in 2007 Central Bank indexed the bolivar multiplying by 1/1000!. Can you see a 1000 times devaluations. Some fellows say that exchange rate “should” index the inflation rate to avoid something named “overvaluation”; they forget that the devaluation is pure inflation tax; it means that between devaluation and inflations lies a completely endless vicious circle.
So Lars the root of our problem is the oil rent property rights, if you can put the oil property in hands of the people you could cut thee institutional nod I mentioned at the beginning of my reply of you proposition which I find OK, but under a different institutional environment. Please be aware that I mention “oil rent property”.
Regards Lars.
Lars Christensen
/ March 10, 2013Alexander,
Thank you very much for your comments. I completely agree that a serious reform of the “oil flows” is needed. That is point 4 in my proposal: “Separate fiscal policy and monetary policy – stop monetary funding of the public budget”
However, I did not go into detail about my views on how to actually separate monetary and fiscal policy because I wanted to focus on the monetary part of my proposal.
But nonetheless I do have some ideas about how reform “oil flows” and I might write a blog post on that topic later. But let me just sketch the idea I have.
First of all I think government should get completely out of the oil business. That would mean privatization of the entire oil sector. The revenue from the privatization(s) should be distributed equally among Venezuelan citizens and put into “citizen accounts”.
Venezuelans should then be able to buy welfare services – such as health care, unemployment insurance and old age pensions and maybe also education. That would mean that citizens could buy welfare services in the free market from private welfare service providers and insurance companies.
That obviously would mean that a lot of the (bad?) services that today is provided by the state would be totally privatized but be funded through “citizen accounts”. There would therefore be an equal distribution of the “oil wealth” among Venezuelan citizen.
Furthermore, the revenue from a tax on oil companies should go directly into the citizen accounts. The tax rate should be modest to provide incentives for investments in the Venezuelan oil industry (it is badly needed as far as I know…) and should be written into the Venezuelan constitution to guard against a politicization of the citizen account system.
This proposal of course would of course have wide ranging consequences, but I believe that it would at the same time liberalize the Venezuelan economy, ensure investments in the oil sector and finally make sure that every Venezuelan citizen will get its “fair share” (whatever that is) of Venezuela’s “oil wealth”.
Alexander Guerrero
/ March 10, 2013Yes Lars, that what your wrote is the unique solution, and that will eliminate the “curse”. Lots of people, well documented scholars have “discovered” something they called “the resource curse” ( la madicion del petroleo) some times named a the “Dutch disease”, for being a price thing, but they are wrong. It is clearly a wrong diagnose for what is obviously a disease, Let us diagnose just as a disease caused by government ownership over the resource.
Regard Lars, I liked your post.
hishamh
/ March 12, 2013Lars,
I’ve been following this topic with some interest, as I’ve been doing a lot of reading in development economics lately. It’s interesting to see the differences in perspectives insiders and outsiders have of Venezuela’s institutional and development problems.
I have to say that I’d be against wholesale re-privatisation of Venezuela’s oil industry, or complete lifting of price controls, mainly from the experience of Eastern Europe in the 1990s. While government intervention into prices and markets has been very costly, removing that intervention can be just as costly. There needs to be a transition period until people and society can adjust and public institutions regain trust. Privatisation can be hijacked by vested interests; lifting price controls would trigger a rapid adjustment of prices, but not of incomes.We need society’s buy-in for radical reform and it’s not going to come if the process is seen as unfair, or livelihoods are threatened. The world doesn’t need another Russia.
How much credibility would a nominal forex/commodity price target have, given that Venezuela’s central bank appears to have no policy credibility? Expectations formation is as important as the target itself. What would be the welfare costs of a sudden withdrawal of government social spending? From the look of things, the bolivar needs to be seriously devalued (officially), but that would also give a big one time boost to the price level. We’re not talking here about a policy shift in a stable and mature economy, but one with multiple problems and with imbalances that have built up over many years.
Also with respect to oil receipts (revenue from a finite natural resource), I’d prefer something along the lines of the Norway model, rather than distribution for consumption. That approach also has the benefit of boosting national savings for investment (assuming of course the political economy pitfalls can be avoided, unlike say, Brazil).
I absolutely agree that price controls, administered exchange rates, and government interference in the markets have to go, but let’s try not to kill the patient in the process.
Lars Christensen
/ March 10, 2013Alexander,
I completely agree. There is no “resource curse” and there is no “dutch disease” either. This is 99.9% about government failure. The proper institutional reform could solve these problems. I unfortunately is not optimistic that we will see such reform – no matter who becomes president in Venezuela.
That said I would hope that some policy makers in Venezuela would be inspired by my suggestions.
Alexander Guerrero
/ March 10, 2013I agree with you Lars, we have to go a little bit longer un our dependence path in order to learn how to build a healthy country with hardworking people able to build its future without leaving the serfdom road, as was put for Hayek in his Road to Serfdom.
Lars Christensen
/ March 12, 2013hishamh – my favourite Malaysian economist – thanks for your comments.
I am very skeptical about “gradualism” when it comes to these issues and gradualism clearly risks a set back in the reform process.
To me Poland – and not Russia – is the model. The reason the process was highjacked in Russia was not that liberalization was swift, but rather the total breakdown of all public institutions.
Furthermore, I would stress I am not arguing that all social spending should be privatized in one go, but that the funding of these measures should be transferred to the “citizen accounts”.
I agree that there is a credibility issue in terms of introducing a USD/OIL basket there is no alternative to monetary reform. Obviously to ensure credibility of a new monetary regime serious fiscal reforms are needed as well.
Furthermore, I fully agree that there needs to be a serious devaluation of the official bolivar rate to reflect fundamentals. If I was in charge I would like devalue the total the level in the black market – something like 20-25 bolivar to the dollar. I would peg the bolivar against the dollar-oil basket at that level.
In someway my suggestion for citizen accounts would be similar to the Norwegian model, but it would be based on individual accounts rather than a big collective pool as in Norway.
Alexander Guerrero
/ March 12, 2013You are right Lars, talking about gradualism, Venezuelan example is the best, and Gradualism high jacked the modernization of institutions and reverted the road to capitalism to a version oil mercantilism. Just have a look our history from 1989 till now.
Caldera’s gradualism (1993-1998) brought Chavez socialist revolution. So we have to start again, the problem is that we do not know when. Privatization is a very funny world to talk about oil, people get confused about. There are thousands ways to define contracts and property rights oil sector. In my post I was clear talking on “oil rent”. Norway’s model will not fit Venezuelan budget redistributive and monetary institutions.
When oil boom arrived into Norway, this was a country with budget and monetary institutions very well developed, indeed Norway was a industrialized country. It is not the case in Venezuela where we are exploding oil from 100 years ago, we changed little from then, or if you like, we did worst in those years regarding quality of budget oil rent redistribution and on central bank.
If we carefully observe the evolution of oil industry in Venezuela, contracts, oil concessions reversion in 1975, nationalization afterward, and renationalization in year 2001, we will discover that in 50 years we did it exactly what Malaysian fellow propose. Have a look at it!!.
hishamh
/ March 13, 2013Lars, absolutely agree – there are different degrees of shock therapy, and some have been proven to work. What I’m worried about is the sequencing.
I certainly think Poland is a much better model than Russia was. In the Polish case, I believe market and price reforms were introduced first while privatisation was held back until quite some time later. Russia by contrast tried to do everything at once.
I also absolutely agree on the currency devaluation – people need market prices for private incentives to work. There also needs to be a legal framework to separate the central bank from the executive branch, especially since its clear the executive branch isn’t above manipulating the monetary system. Obviously, that might take some doing.
Alexander,
One of the emerging issues in development economics is the curse of the “outside expert” coming in and offering advice to supposedly “know-nothing” locals 😀
As a Malaysian, I’m well versed with the phenomenon, having experienced it from both sides.
So take any and all outside advice – mine, Lars, the World Bank, the IMF whoever – and take what you think will work and forget the rest. In the end, it’s up to the people of Venezuela to decide their own course and their own future.
Good luck!
John M. Wilkins
/ December 20, 2013They have done exactly the opposite of what should be done with an economy. Venezuela is a sovereign country with a sovereign currency like the U.S., japan, Canada, etc. and they should have no problem paying their bills. They have complete power over their currency. However, they have given that power away. First, they set price controls and other measures that caused massive shortages of goods which caused the high inflation, Money printing is a response to inflation, not the cause. Second, they need to let their currency freely float. Yes, that will be painful but it will get rid of the competitive imbalances quickly. Pegging a currency is exactly the opposite of what should be done. Third, they need to stop borrowing any foreign currency. Borrowing foreign currency exacerbates the exchange rate problem. The government needs to get their nose out of the economy and do the three things outlined.